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Are We At The Beginning Of A Bear Market In Commodity Prices?

August 25, 2014

A cyclical bull market in commodities began right after the start of the new millennium. Many commodity prices zoomed to new actual all-time highs, not adjusted for inflation. Consider that crude oil, which peaked at $41.15 per barrel prior to 2004 reached over $147 in 2008. Today it remains over the $90 per barrel level- more than double the pre-2004 high. Gold traded at a high price of $850 an ounce in 1980, in 2011 it shot up to over $1,900 and remains north of $1,200 today. The examples go on and on- copper and other base metals; agricultural commodities and some soft commodity prices all saw new dizzying heights over the past decade. At the same time currencies of countries that depend on commodity production for revenues and are freely traded, namely the Australian and Canadian dollars, strengthened dramatically during the same period.

The spring and summer of 2014 presents a change…

Recently we have seen a reversal of fortune in the world of some commodities. While not all commodity prices have moved dramatically lower, decreases in the price of grains and oil could be sending us important signals of things to come.

Grains are weather commodities. During temperate years when harvests are plentiful prices tend to drop. During years of weather events drought, excessive rains and storms or even periods of disease that affect crops prices tend to rise. The 2014 growing season has been one of the best on record with ample crops resulting in a dramatic price correction. Key grain prices have plunged between 18-27.5% since spring. In 2012 severe drought conditions created sky high grain and food prices. Lower grain prices, given weather conditions this crop year, make perfect sense. However, the action in another commodity gives reason to pause and consider if there is something bigger brewing.

Given an increase in geopolitical tensions in oil producing regions, it may appear odd that the price of the commodity slipped sharply over past weeks.

Crude oil, the mother’s milk of energy markets, plunged over 11% as violence and instability continues to rage across the Middle East. Tensions between the West and Russia, a significant world oil-producing nation, over Ukraine would have caused the price of oil to move higher in years past. New sources of higher cost oil production in the US and Canada have alleviated traditional fears of a supply shortage.

Grains and oil are just two examples of commodities that have moved lower. Not all commodity prices have come under such pressure over past months however overall commodity price indices have moved to the downside. Moreover, there may be another sign that the bull may have run its course.

A reversal in the trend for commodity currencies?

Two currencies highly correlated to commodity prices are the Australian and Canadian dollars. Each nation is a commodity producer and each has huge reserves of raw materials within their borders.

As the chart illustrates, these currencies increased dramatically during the years of the commodity bull. With the exception of 2008, where the global financial crisis caused all asset prices to fall, the Canadian dollar moved from an exchange rate of 63 cents to the US dollar in 2001 to a high of over $1.10 in 2007 and over $1.06 in 2011. This represents an increase of over 74% from low to high. The Australian dollar moved from just under 48 cents to the US dollar in 2001 to a high of just under 98 cents in 2008 before once again surging and topping out at $1.10 in 2011. That increase amounted to a whopping 129% from low to high. The chart shows that lately the high flying “commodity currencies” have been under some pressure with the C$ currently at the 91 cent level and the A$ at the 93 cent level, both over 15% below their highs. Technically, these uptrends, in place for a decade, seem to have reversed. Could this be additional proof of a commodity bear market on the horizon?

Changes in the commodity business itself…

The ultimate commodity consumer has been China where enormous economic growth has fostered infrastructure building requiring the use of raw materials or commodities. In 2014, we have witnessed a slowdown in the level of Chinese growth coupled with economic stagnation in Europe and the US. Lower consumption levels will eventually result in lower prices.

Moreover, there have been big changes in the commodity business itself given increasing regulation on the US. Banks, which during the last decade became dominant centers for commodity trading. Most have left the business. Commodity trading has reverted to traditional merchant companies such as Glencore, Nobel, Mercuria, Trafigura, Cargill and Louis Dreyfus to name some of the heavy hitters. Many of these companies are now domicile outside the reach of US regulators. Today these trading giants have more capital than the commodity trading companies of years past. The ability for these commodity merchants with strong balance sheets to exert influence on prices, production levels and all aspects of raw material markets has increased and is now concentrated in the hands of a powerful few. Many of these trading houses have taken significant stakes in commodity production, case in point Glencore’s US$29 billion merger with Xstrata. Lower commodity prices will give these blossoming giants the opportunity to scoop up new production assets at discounted prices. In the past commodity merchants profited handsomely during bull markets, bear markets were lean years. Now these companies can use downturns to add to their base holdings so that the next upturn will create even greater rewards.

Has the commodity Bull Run its course?

The recent drop in oil and grain prices, lower trending commodity currencies and commodity indices may portend the beginning of a bear phase for commodities. However, some believe the commodity bull has not run its course.

Years of artificially low interest rates fostered by the governmental monetary policy of easing and asset purchases stoke inflation concerns as a potential backlash of those policies. It is possible that demographics- population growth and increasing wealth in emerging markets will foster increasing demand for finite raw materials in the years to come. The CEO of the largest commodity trading company and the third-largest mining company in the world by market value, Ivan Glasenberg, believes in a continuation of the global commodities boom. Glencore announced a $1 billion share buyback and an increase in the dividend it pays to shareholders on August 20. Glasenberg said, “The supercycle ain’t over, China is still buying, demand for commodities hasn’t tapered off, it’s even higher than it’s ever been.” He went on to say, “Demand is pretty good. We’ll grow. We may do more acquisitions where you’re not creating more supply in the market.” Glencore has a market capitalization of around US$80 billion. Moreover, if there is a continuation of the dip in commodity prices you can bet your bottom dollar that companies like Glencore and the Chinese stand ready to vacuum up what they believe are cheap commodity producing assets.

We are at a critical juncture for commodity prices now. Oil, grain and commodity correlated currencies may well be signaling a downturn in what can only be described as a mature bull market for raw material prices. One thing is for certain, any downturn will create opportunities for consumers as well as those looking to make significant investments who are currently sitting on big piles of cash.

Stay tuned…

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